Author Katrina Shanks, CEO Financial Advice NZ Article originally published in Stuff.co.nz.
Do you ever wonder why some people seem to be better off than others when they appear to have similar lives and track consistently with incomes, families, and lifestyle? It’s usually because they have better financial behaviours, and many of them take advantage of that powerful tool known as compound interest.
It’s so powerful that the story goes when Albert Einstein was once asked what mankind’s greatest invention was, he said: “Compound interest.”
If you compare compound interest to a horse, it’s not a thoroughbred – it’s more like a workhorse.
And like all workhorses, it needs to be considered, well feed, watered and can be trusted to do its job.
So, let’s look at the workhorse of the financial world.
Compound interest is quite a simple concept: It’s when you earn interest on both the money you have saved and the interest you earn on that money. Every year you earn interest on the interest again so, in effect, interest compounds on interest.
Basically, it’s your money working for you instead of you working for your money.
United States author, inventor, and scientist Benjamin Franklin described it this simply: “Money makes money. And the money that money makes, makes money.”
But compound interest can work against you as well as in your favour. If you have debt then you could be paying compound interest on the money you have borrowed.
But let’s focus on compounding interest on your savings (now that you have your New Year’s resolutions and are planning to save a little more this year).
Here are four quick tips to get that savings going this year, so you can benefit from compound interest.
Review all your income and expenditure for the past three months and see if there’s any wastage you can tighten up on to provide a surplus.
Take those surpluses you have now created and put them into another account to help ensure you don’t spend them. And then transfer that amount every pay day.
Decide your priority for these surpluses – maybe paying off your credit card, creating an emergency fund for peace of mind, putting it into KiwiSaver if you are saving for a home, or even into a managed fund.
Try to be disciplined with these new funds and ensure they’re used for the purposes you’ve decided on to meet your needs and goals.
Let’s look at the effect of compounding interest on your savings.
Remember, the earlier you start with savings the greater the compound interest you’ll receive.
Your money working for you – sounds great, right?
I’ve taken these calculations from the Sorted.org.nz website: This example is saving $10 a week from the age of 20. The results are based on an interest rate of 2.5 per cent after tax and allowing for inflation.
Of you start saving $10 a week when you are 20, then by the time you are 60 you would have saved nearly $15,000, adjusting for inflation. Without that inflation adjustment, you end up with $31,716, of which $10,916 is compound interest.
Compound interest does a lot of heavy lifting in terms of increasing your wealth.
I used $10 because most people could save $10 a week, but imagine if you increased this every year to align with a pay increase or a new job.
The impact on your savings and wealth could be significant.
Once again, this comes down to good financial behaviour.
Start when you’re young, and you could be set up for life by just chipping away. Even if you’re older it’s never too late to reap the benefits of savings.
Compounding interest is so simple, but it’s never in the front of our minds when we consider why saving is so important or just how effective it can be in the long term.
In the words of my financial adviser – have a plan, review the plan, stick to the plan, and then enjoy the plan.
Financial security and freedom can occur with just a few small changes.
Make a positive change for you in 2022. Save today.
Financial Advice New Zealand chief executive Katrina Shanks